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Google's Checkbook Spoils Microsoft-Yahoo Deal

Posted on: Tuesday, 6 May 2008, 00:05 CDT

Shortly after Microsoft announced its hostile bid for Yahoo, Google objected and raised the prospect that it would take its opposition to the merger to U.S. government regulators.

As it turned out, Google was very much the spoiler in the deal, which fell through when Microsoft withdrew its offer, worth $47.5 billion, this weekend. But Google's most effective weapon was not coercion or threats, but the very effective, and unconventional, use of its own checkbook.

Google and Yahoo recently conducted a two-week test in which Google delivered ads on a small portion of Yahoo searches. The test, which both companies described as successful, was intended to show how much more Yahoo could earn by outsourcing some of its search ads to Google, whose technology and large base of advertisers allow it to extract more revenue on average for every search.

Microsoft's chief executive, Steven Ballmer, said that the prospect of such a deal, which would deprive Microsoft of the ability of selling all the search ads on Yahoo, made proceeding with a hostile takeover less attractive. For Yahoo, the promise of a big check each quarter from Google could placate enough shareholders to head off a revolt over its decision to turn down Microsoft's offer, worth $33 a share.

On Monday, investors sent Yahoo shares tumbling by as much as 20 percent in early trading before they recovered somewhat. In afternoon trading Monday, shares of Yahoo were down $4.47, or 15.6 percent, to $24.20. Microsoft's shares were up 0.5 percent while Google's rose 1.7 percent.

Even though Google is far and away the leader in search advertising, it is rare for a company to help its biggest rival this way. Google's offer is all the more unusual because it does not neutralize Yahoo as a potential future competitor.

Yahoo's stated plan is to take that money and continue to develop its own search advertising system, which is meant to rival Google. When Yahoo's own technology is good enough, it will presumably start selling its own ads, and try to destroy the company that had thrown it a lifeline.

So why would Google do this?

Eric Schmidt, the Google chief executive, portrayed the decision as a gesture of friendship.

"It's nice to be working with Yahoo," he told analysts last month. "We like them very much."

There may be a bit of truth to that. Google's founders, Larry Page and Sergey Brin, have been friendly with Jerry Yang and David Filo, the founders of Yahoo. All studied, and cooked up their companies, at Stanford University.

Moreover, Yahoo gave Google its big break, hiring the fledgling company to power the searches on Yahoo.com. Many suggest that Google would never have established itself with Internet users were it not for the promotion it received from Yahoo, which put Google's name and logo on every Yahoo search results page.

The other explanation, not mutually exclusive, is that Google fears Microsoft far more than it fears Yahoo. That is odd, perhaps, because in Google's most important markets, Web search and online advertising, Yahoo is a bigger and more effective competitor than Microsoft.

But Microsoft has far more money and engineering bench strength than Yahoo does. Moreover, Microsoft has quite a history trying to best rivals through tough tactics and exploitation of its Windows franchise.

Google has made it no secret that the rival it is most concerned about is Microsoft, and it has raised several objections to the prospect of a merger. In any case, a combination of Microsoft and Yahoo could be a tougher competitor to Google than either separately.

Most significantly, Google acts as if it has the confidence that it can win in the market. For example, Google has long provided a very rich advertising deal to Ask.com, a smaller rival. Ask.com has also tried to build its own search advertising system, with little impact so far.

Analysts say that a deal with Google could have multiple benefits. It would allow Yahoo to use the extra revenue to invest in its own ad system. A limited partnership could help get around the antitrust scrutiny that a broader deal would most certainly face from regulators. The U.S. Justice Department has already begun asking questions about the companies' relationships.

Some observers in Silicon Valley say that a deal with Google made sense before the Microsoft offer and makes sense now.

"If Yahoo were to put as much attention into its product as it put in catching Google in search monetization, it would be doing fine," said Roger McNamee, a veteran technology investor and the co- founder of Elevation Partners, a private equity firm.

How long Yahoo's stock will stay down will largely depend on the company's next actions. Its successful resistance to Microsoft's pursuit set up a clear challenge for Yang: prove to investors that the company is worth the $37 a share price for which he would be willing to sell it.

People close to Yahoo said that Yang and his team greeted Microsoft's withdrawal as a victory. High-fives were exchanged Saturday when they learned that Microsoft was backing down.

Yet some Yahoo shareholders, large and small, have indicated that they favored a deal at around $34 to $35 a share. Even those who were holding out for a higher price said a merger with Microsoft made strategic sense.

The entire board supported Yang's desire to reject the Microsoft offer, said a person involved in the negotiations who was not authorized to speak publicly about the matter. But unhappiness with Yang could spread through the ranks of the company.

"If the stock drops as far as I think it will, a lot of employees are going to be angry and many key employees could leave," said a Yahoo executive, who asked to remain anonymous to avoid upsetting his superiors.

For Yahoo, the idea of letting Google run some of its search ads is not new. Some shareholders and even some Yahoo executives have long favored it.

But before Microsoft made its offer, Yang and his team had repeatedly rejected the idea, saying that search advertising was an essential part of the company's long-term strategy. Instead, the company spent millions in improving its own search advertising system, called Panama, telling investors it was the right choice.

In the letter to Yang, Ballmer used precisely those arguments to emphasize why a search advertising partnership with Google was a bad idea. A partnership with Google "would fundamentally undermine Yahoo's own strategy and long-term viability by encouraging advertisers to use Google as opposed to your Panama paid search system," Ballmer said.

Source: International Herald Tribune

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